THE BALANCED SCORECARD
Why businesses need a balanced scorecard
The balanced scorecard was developed by US academics Robert Kaplan and David Norton in response to the shortcomings of traditional financial measures.
• Traditional financial measures are one-dimensional. By definition, they only look at the financial aspects of a business.
• Traditional financial measures are historical. They tell us nothing about what may happen to the business in the future. There are many examples of businesses that have achieved rising profits, as measured by historical financial results, at the same time as there were underlying problems. Eventually the problems have led to a downturn or even a business failure.
• Conventional financial statements do not explain variances from the expected outturn. Why did things go wrong? There are not necessarily any clues in the figures themselves. To understand the problems, some other perspectives on the business are needed other than the purely financial.
• Financial measures can be manipulated. There are several notorious examples of where preparers of financial statements have deliberately set out to mislead – Enron is simply a recent example. Even where there is no blatant intention to mislead, there is considerable subjective judgment involved in the preparation of financial statements. This also allows the preparers to manipulate the figures.
Kaplan had already discussed some of these issues in a book, ‘Relevance Lost’, written with T Johnson in 1987. ‘Relevance Lost’ argued that traditional management accounting had failed to keep pace with changes in IT and new ideas about business.
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Kaplan and Norton based their ideas about the balanced scorecard largely on a study, ‘Measuring Performance’, sponsored by accountants KPMG. This study looked at how businesses measured performance in practice. They came across several examples of how businesses used measures other than purely financial ones. In one business, the quality manager had pushed the CEO to include quality metrics at the top of a weekly management meeting agenda as well as financial metrics, which had always been the first item on the agenda in the past.
Since Kaplan and Norton published the first article about the Balanced Scorecard in the Harvard Business Review in 1992, the concept has become adopted widely throughout industry.
Developing performance objectives
There are several steps in preparing a Balanced Scorecard, as follows:
• Define a vision for the organisation
• Develop performance objectives
• Develop appropriate measures
• Report using the Balanced Scorecard.
The first step is to define a vision for the organisation. Such visions are more than just dreams – they are based on strategic choices about what the organisation is in business to achieve.
These choices are not arbitrary – they depend on the interplay between (a) stakeholder objectives, (b) the resources available to the organisation and (c) an analysis of the market in which the organisation is operating.
The vision for the organisation might typically take a form such as ‘We want to be known as the top recruitment agency in the South-East for filling jobs in accounting and finance’.
The vision typically expresses where the business wishes to be in two to five years’ time. However, to get to that point in the future, there are more immediate steps that have to be taken today and tomorrow. These are defined by the business’s performance objectives.
The balanced scorecard approach groups these objectives under four headings:
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• business process Perspective">internal business processes
• Learning and Growth
Performance objectives flow from the business’s vision. They are therefore specific to the business – one business’s performance objectives can be completely different from another’s. In developing a balanced scorecard, we therefore need to think very carefully about what are appropriate objectives for this business.
Satisfying customers’ needs is paramount in most organisations. To give an idea of the specific performance objectives that an organisation might set itself, it is worth considering the range of needs that a customer might have.
Access is one of the most basic needs. The customer needs to be able to access the product or service. So, for example, a supermarket chain needs to ensure that a new supermarket is accessible by car, foot or public transport to shoppers in the catchment area.
Security is another basic need. In the context of a supermarket, this would mean providing customers with the reassurance that the goods are safe – they are within their sell-by periods and won’t give us food poisoning.
Other basic needs that customers have of a product or service are competence (ie in the way the service is delivered), reliability, durability and responsiveness.
The needs that we have discussed so far are often called ‘hygiene factors’, because in many markets they are simply taken for granted, like normal standards of hygiene. What can make a business really successful is meeting more sophisticated needs.
Style – Clearly, in an industry like fashion, capturing the consumer’s need for something a bit special or out of the ordinary is essential. But even a supermarket can trade on this – middle class shoppers prefer Waitrose supermarkets because they have a certain style lacking in Kwiksave or Somerfield.
Performance v expectations – If a business can exceed customers’ expectations, it can steal a march on its competitors. This is not always easy – once you have exceeded a customer’s expectations once, the higher standard of service can come to be taken for granted. But it is a powerful way of impressing the customer.
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Credibility – Customers are often looking for more than just a good quality product or service. They want to feel that the provider is a credible organisation. By this we mean an organisation in which the consumer can believe, and that the consumer can feel proud of supporting. For many years Body Shop has sought to gain this kind of credibility with customers who are opposed to the use of animals in product testing, and will therefore shop at Body Shop because they share its values.
To conclude with an example, a supermarket might set itself the following customer-facing objectives:
1. Minimise stock-outs (competence)
2. Keep waiting time at the checkouts down to two minutes (responsiveness)
3. Ensure staff provide service with a smile (style)
Internal Business Processes
Another set of performance objectives relates to the business’s internal processes.
A useful framework for looking at internal business processes is provided by the value chain, which breaks down these processes into ‘primary’ – ie those that create value for the customer directly – and ‘secondary’ – all those other process that are needed to support the primary processes.
Primary processes include:
Inbound logistics – eg delivery of raw materials to the factory
Operations – eg the manufacture of goods
Outbound logistics – eg delivery of finished goods to the customer
Marketing and sales – without which there would be no sales in the first place
Service – needed to ensure that the product is maintained after shipment.
Secondary processes include:
Procurement – eg buying the raw materials needed for the product
Human resources management
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Management systems – which includes all support functions in the business such as the accounts department.
A manufacturer might set himself the following internal business process objectives:
1. Ensure suppliers can deliver at 24 hours notice (procurement, inbound logistics)
2. Manufacture each unit of product within 24 hours of picking components (operations)
3. Keep level of defects below 1% (operations, technology development).
Learning and Growth
A third set of objectives relate to learning and growth. These objectives focus on the future of the business. The idea here is that if there is no focus on the future, and on continual learning and growth, then the business cannot expect to continue being successful into the future.
Objectives in this area are often difficult to define in specific terms. One way of coming up with a valid set of objectives is to look at what the writer Pete Senge considered to be the five essential disciplines of learning organisations. An organisation that embraced these five disciplines was equipped to develop for the future.
Senge’s five disciplines are:
• Systems thinking – the idea that all events influence each other. In an organisational context, this means that an individual or department cannot go their own way; it have to work with the rest of the organisation.
• Personal mastery – individuals need to be proficient at what they do. This means getting appropriate training and development.
• Mental models – the organisational needs tools for understanding the world in which it operates.
• Building shared vision – if the organisation is to be successful, everyone must be committed to the vision.
• Team learning – the organisation’s members must develop by learning from each other and from their mistakes.
An organisation might set itself the following objectives:
1. Ensure all staff are either professionally qualified in their area of expertise or are working towards a professional qualification (personal mastery)
2. Ensure all staff buy in to the organisation’s vision (building shared vision)
These objectives are the conventional ones that are seen in most organisations of any size. They can be grouped according to what they relate to.
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• Operating performance (as shown by the profit and loss account)
• Financial position (as shown in the balance sheet)
• Return on investment.
An organisation might set itself the following objectives:
1. Achieve sales growth of 20% per annum (operating performance)
2. Do not exceed overdraft limit (financial position)
3. Provide investors with a 15% return on capital employed (return on investment).
Developing appropriate measures
The next step in the process of preparing a balanced scorecard is to develop ways of measuring our performance against the objectives. If we cannot measure our performance, we have no way of finding out whether we have met the objectives.
Typically, a balanced scorecard will have between two and four measures for each of the four perspectives, making a total of (say) ten measures. A bigger number of measures would be too difficult for management to focus on.
The measures used in the balanced scorecard can go well beyond the traditional financial measures that are seen in a set of financial statements, and often do. To be useful, however, they must meet certain criteria. They must be:
Understandable – those in the business must understand what the measure means. Otherwise, they will not be able to interpret it.
Relevant – the measure must be relevant to the performance objectives.
Material – the measure must relate to something which will materially impact the performance objectives. For example, the number of ‘phone calls put through to staff on the supermarket floor is unlikely to have a material impact on the waiting time at checkouts.
Reliable – the measure must be reliable. Financial measures can be audited, which gives some reassurance about their reliability. But not all the measures we use are checked in this way.
Comparable – the measure of performance must be capable of being compared, whether with last year’s performance, with our targets or with our competitor’s performance.
We now turn to considering appropriate measures to use for the four different ways of looking at the business. These measures are simply examples of what may be appropriate – the specific measures to use in individual situations will depend on the performance objectives that we have set ourselves.
... operational measures on customer satisfaction, internal business processes, innovation and learning activities. It is these operational measures that will fuel the performance of future financial measures. The ... in how to make processes efficient. 4. Financial Perspective: How do we look to shareholders Financial measures indicate how healthy a company is. Typical ...
Many of the measures used here derive from market research. Market research can tell us what the customers thinks of our products or services and therefore allows us to establish whether we are meeting customer needs.
Market research can be quantitative or qualitative. Examples of measures derived from quantitative market research are:
• Frequency of purchase
• Value of purchase
• Contribution to total revenue.
In the supermarket context, this type of data can usually be extracted from the supermarket’s IT systems, which capture the data at point of sale.
Examples of measures derived from qualitative market research are:
• Attitude to product / service
• Level of awareness
• Customer satisfaction.
Market researchers will use customer surveys to gather this type of information. They might use focus groups as an opportunity to explore customer views in more depth.
Data generated from market research usually comes from outside the organisation. Other externally generated measures of performance, from the customer’s perspective, include market size and market share. Industry bodies may well publish this type of information for a particular sector.
There is also considerable information that can be generated from within the organisation that can help us establish whether we have met our performance objectives. The advantages of using internally generated information is that it is often cheaper to obtain and may be more reliable.
Examples of internally generated measures are:
• % goods returned (the higher the percentage, the more dissatisfied customers will be)
• number of new customers per week / month / year (this shows how successful we are at expanding our customer base)
• repeat customers (this shows whether we are building a loyal customer base)
Internal Business Process Perspective
The measures used here will inevitably depend on the nature of our business. Processes differ according to what business we are in.
For a business involved in producing goods, typical measures might be:
• % defects
• % raw materials scrapped
• % variance from standard hours required for production
For a service business, typical measures might be:
• Response times (eg in a call centre)
• Value added (if I am a tax specialist, how much have I saved my customer in taxes?).
Learning and growth perspective
It is not easy to measure performance in this area, as the performance objectives themselves are somewhat intangible – eg a sense of commitment to the business, a happy workforce.
In practice, businesses often use employee surveys. Typically, employees complete a confidential questionnaire which is processed by an independent third party. The questionnaire responses are then summarised and fed back to management in a way that ensures that no individual employee can be identified as having expressed a particular view.
The employee survey can be used to measure:
• Quality of communication within the business
• Employee satisfaction.
Other measures that can be used in this area are employee qualifications (as a measure of how well-trained the workforce is) and number of innovations generated by the business. Innovations will not necessarily benefit the business financially today, but they may well do so in the future. Pharmaceutical companies pay particular attention to measures of innovation in their research and development operations. A typical measure is the number of new patents obtained each year, on the basis that a patented drug offers the potential of revenue streams in the future.
Examples of measures here are as follows.
• Gross profit as % sales
• Overheads as % sales
• Operating profit as % sales
Managing financial position
• Days in debtors
• Days in stock
Return on investment
• Return on sales
• Return on capital employed
• Residual income
• Dividend payout ratio
Having produced a number of measures of performance for each of the four ways of looking at the business’s performance – customer perspective, internal business process perspective, learning and growth perspective and financial perspective – there are practical issues in implementing the balanced scorecard.
Information systems – The business must have systems that are capable of generating these measures easily. Ideally, the systems must also be able to marry the different sets of data so that management is presented with a single web page, or a single sheet of paper, that sets out in one place how the business is doing on all (say) ten measures.
Dependence on third party information sources – If the measures are externally generated, rather than internally generated, the business needs.
Reliability of non-financial data – Is the data reliable? Is there any way in which it can be audited?
Balancing interests of different stakeholders – One of the problems in using the balanced scorecard is that different measures reflect different stakeholders’ needs:
• Measures of customer satisfaction reflect what customers want
• Measures of learning and growth reflect what employees want – ie good quality training, a congenial workplace
• Financial measures reflect what investors want – eg dividends and capital growth.
Ideally, what is good for one group of stakeholders will also be good for the others. But it is not difficult to see how there can be conflicts. For example, providing a top quality service for customers might be more expensive, and reduce returns for investors.
Linking to employee compensation – One way of ensuring that employees focus on the measures in the balanced scorecard is to link their compensation to success as measured in this way. Increasingly, bonus schemes are linked to the balanced scorecard in businesses that have adopted the balanced scorecard approach.